Regulating Crypto Assets

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Cryptocurrencies have been holding the financial world in nervous fascination ever since the first one was launched in 2009. These digital or virtual currencies, which use cryptography – “the process of converting legible information into an almost uncrackable code to track purchases and transfers” – are a medium of exchange based on decentralised control. In theory, they are invulnerable to government interference or manipulation. Now grown to more than 1,600 in number, the revolution cryptocurrencies promised to bring about in finance is elusive while the lack of regulation is causing the financial world some serious concern.

Think20 (T20), an engagement group that provides policy ideas to the G20, has suggested to it that it design a cross-border regulatory framework to put Crypto Assets (CA) – the official term – on a level playing field with other competing financial instruments and activities and monitor closely the risks they pose to users, investors and to society.

The systemic risk due to CA is as yet negligible because the asset class is still nascent. But signs of expansion are evident. CA quotations and advertisements are moving to the financial pages of mainstream newspapers, bitcoin ATMs are increasing in number, and more merchants accept payments in bitcoins that are automatically converted into fiat money through the financial system.

These marketing efforts frequently target individuals, who have enthusiastically embraced CA – and CA are clearly not suitable for non-speculative investors due to their extremely volatile nature and lack of intrinsic value. For example, market capitalisation – that surpassed $ 750 billion in January 2018 – dropped to around $ 260 billion in late June. Bitcoin (the first cryptocurrency, launched in 2009, which currently represents 40% of the value of the asset class) saw its price drop more than two-thirds from its peak in December 2017, a sign of feverish growth declining. Vitalik Buterin, co-founder of Ethereum, regarded the world’s second-most valuable cryptocurrency network behind Bitcoin, has said on his own twitter account that “Cryptocurrencies could drop to near zero at any time.”

The current CA market fever needs careful handling. Investment bank Goldman Sachs is planning to launch a bitcoin trading desk to offer clients a non-deliverable forward that will be linked to bitcoin. Eventually, the bank hopes to receive regulatory approval from the Federal Reserve and state-level authorities to begin trading actual bitcoins – “physical bitcoins” – a development that will cement the flagship bitcoin’s status as a mainstream financial asset. Trading in standardised futures was authorised by the U.S. Commodities Futures Trading Commission in 2017. Both Chicago’s main stock exchanges, the Chicago Board Options Exchange and CME, launched contracts on bitcoin in December 2017 (though transaction volumes remain very low). If negligence prevails, a debt-financed boom in the asset class could turn into a serious financial problem.

High volatility apart, the non-linear nature of exchange activity benefits greatly from network effects and economies of scale: easily replicable, there are more cryptocurrencies than conventional ones, but they also have a high mortality rate, with few having a chance to become monies. In comparison, plain old vanilla paper currency´s elastic supply – fit to match the up and downs of the demand for money – provides the basis for a stable price environment, which is crucial for a monetary system to function properly. CA lack that kind of flexibility. Nonetheless, CA monetary services might, therefore, become a useful alternative in highly unstable regimes, prone to currency substitution, especially when capital controls are not in place.

While managing its risks, the framers of the T20 proposal are looking to give technology space to develop its genuine potential. Even cryptocurrency’s critics grant that the underlying technology might contribute to a major improvement in payment systems – especially in cross-border payments and smart contracting – resulting in financial inclusiveness and economic efficiency. Also, CA’s use in international remittances brings costs down sharply.

Since the essential technology is open-source (and not proprietary), its potential benefits will be transferred to consumers through competition and not harvested by CA investors.

The T20 proposal is not intended to regulate more, but on an equal basis. And regulation must not wait for CA to reach overarching importance as problems could be more easily fixed now than when the system might be in danger. It should monitor activities, not entities alone, and keep a close watch on CA linkages with the real economy and the existing traditional financial infrastructure.

The proposal must aim also to bring CA under the conventional Anti-Money Laundering (AML) and Counter-Terrorist Financing (CTF) standards. Being anonymous and decentralised, CA can be an alternative way to make payments, transfer funds and store liquid wealth for these purposes, the lack of proper AML/CTF surveillance only strengthening this possibility.

As early as 2013, the U.S. Financial Crimes Enforcement Network (FinCen) published guidelines, suggesting that the mining or trading of Bitcoin as well as the operation of exchanges on which Bitcoin is traded, falls under the label of “money service businesses” and therefore, ought to be subject to the same AML and Know Your Client (KYC) measures as other financial institutions. The San Jose Principles (2017), developed by the Financial Action Task Force (FATF) within its FinTech and RegTech Initiative, should provide a balanced approach to regulators.

Bubbles occur, even with more traditional, extensively regulated financial instruments that operate with higher transparency, and CA too need action plans for amendation. For example, the regulators must pre-empt a possible consequence of uncontrolled proliferation: the dumping of CA and Initial Coin Offerings (ICOs)on the public, making it easy for CA creators, experts and early investors to cash in and leave the table. Facilitating increased access to the more established markets – with their greater liquidity pools – is an easy way to inflate prices first, and then pave the road for the exit strategy. The CA experience shows the need to establish strong rules to promote market integrity and protect investors and consumers not only from this sucking game, but from a wide array of threats, including fraud and cheating scams, hacking, outright theft, closure of exchanges, price and exchange rate manipulation and others.

A true global cryptocurrency might emerge in the future, an improved version compared to the pioneers in CA today. Their underlying technology – such as blockchain – holds bright prospects. Yet, a market bubble in CA deserves careful attention. Regulating it on par with other monetary alternatives is a logical step.

José Siaba Serrate is Counselor Member, The Argentine Counsel of International Relations (CARI).

References

  1. Investopedia, “cryptocurrency”, <https://www.investopedia.com/terms/c/cryptocurrency.asp>
  2. According to CoinMarketCap, a specialised website.
  3. Economists are unable to agree even on a minimum fundamental value of a bitcoin.. http://review.chicagobooth.edu/economics/2017/article/what-s-fundamental-value-bitcoin
  4. Its five basic principles are as follows: i) Fight terrorism financing and money laundering as a common goal; ii) encourage public and private sector engagement; iii) pursue positive and responsible innovation; iv) set clear regulatory expectations, and smart regulation which addresses risks and allows for innovation; and v) fair and consistent regulation. Aim for a regulatory environment that is commercially neutral and respects the level playing-field.

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